Financial Accounting

Prepared by
Hewage Rishan Sampath, Ph.D.
Senior Lecturer
Dept. Accountancy & Finance
Faculty of Management Studies
Sabaragamuwa University of Sri Lanka
FINANCIAL STATEMENTS
ANALYSIS
 Financial Statement Analysis
Analyzing Financial Statements;

•Analyzing financial statements highlights the important

relationships in financial statements

•It evaluates the past performance of the business

•Assess the company’s strength with liquidity, profitability,

operational efficiency, and growth

•Give direction to decision-makers to forecast and plan future

performance based on past performances
 Weakness of Financial Statement
Analysis
The results of financial statement analysis may sometimes;

•Mislead the user

•Make limitations when planning future performances depending on past

•It does not consider the qualitative aspects of transactions

•The results are hard to compare with other companies since the policies and
strategies of competitors are different

•Results may be wrong due to wrong judgement

Methods of Analyzing Financial Statements
• Horizontal Analysis
• Vertical Analysis / Common-Size analysis
• Trend Analysis
• DuPont Analysis
• Ratio Analysis
 Horizontal Analysis
Using
Using comparative
comparative financial
financial statements
statements to to calculate
calculate
rupee
rupee or or percentage
percentage changes
changes in in financial
financial statement
statement
item
item from
from one
one period
period toto the
the next
next
 Horizontal Analysis Value basis

Here it calculates the changes in rupee amounts

Rupee = Current Year – Base Year

Change Figure Figure
 Percentage Change
Calculate the changes as a Percentage compare to base period.

Percentage = Rupee Change 100%

Change Base Year Figure
×
 Vertical Analysis
In a single financial statement, each item is expressed as
a percentage of a significant total.
e.g.
•allincome statement items are expressed as a percentage
of sales
•Financialposition statement items are expressed as the
percentage of total assets or total equity and liability
 Trend Analysis
Show
Show changes
changes over
over time
time in
in given
given financial
financial statement
statement items
items
within
withinaaseveral
severalyear
year
 DuPont Analysis
In
In 1920,
1920, DuPont
DuPont Corporation
Corporation introduced
introduced this
this technique
technique for
for better
better analysis
analysis of
of
company
company profitability
profitability with
with comprehensive
comprehensive understanding
understanding of of Return
Return onon Equity
Equity
(ROE).
(ROE).

Dupont
Dupontanalysis
analysisisisan
anexpanded
expandedversion
versionof ofthe
thereturn
returnononequity
equityformula
formulawhich
which
can
can be
be used
used to
to determine
determine how
how well
well the
the company
company utilizes
utilizes its
its equity
equity capital
capital to
to
generate
generateincome.
income.

Dupont's
Dupont's analysis
analysis isis aa combination
combination of
of three
three ratios;
ratios; Net
Net profit
profit margin,
margin, assets
assets
turnover
turnoverratio,
ratio,and
andfinancial
financialleverage
leverage(Equity
(Equitymultiplier).
multiplier).

- Three-step Dupont Analysis Formula;

 Ratio Analysis
Expressing
Expressing thethe logical
logical relationships
relationships between
between financial
financial
statement
statement items
items ofof aa single
single period
period
e.g.
e.g.
Percentage
Percentage relationship
relationship between
between revenue
revenue and
and net
net
income/
income/ profit
profit
 Advantages of Ratio
Analysis
• It simplifies the financial statement figures

• Helps in comparing companies with different sizes but operates in same industry

• Helps in trend analysis which involves comparing a single company over a period.

• Highlights important information quickly by simple form

• The user can make judgments by just looking at few numbers instead of reading the
whole financial statement
Limitations of Ratio Analysis
It is hard to compare one company to another since companies operate in
different industries and different environmental conditions.

Financial accounting uses estimates and assumptions that may leads to change
the ratio values.

Ratio analysis uses past information while users are more concerned about
current and future information.

Past inefficiencies/abnormities may mislead users

 Classification of Ratios

• Profitability Ratios

• Activity/efficiency Ratios

• Liquidity Ratios

• Solvency Ratios

• Market prospect ratios / Market value ratios

 Analyzing of Profitability
Profitability can be measured at different levels. However, there are five
common estimations of company profit margin;

•Gross profit margin

•Operating profit margin

•Operating Ratio

•Pretax profit margin

•Net profit margin

The profit margin is calculated as a percentage of its sales.

 Profitability Indicator Ratios
In addition to analyzing the profit of the company, analysts
can scrutinize the company’s profitability with the following
indicators;

•Effective tax rate

•Return on Assets

•Return on equity

•Return on capital employed

 Gross profit margin
The gross profit margin presents how efficiently a company
generate profit on sales after deducting cost of goods sold. It
is the profit that a company yield before deducting additional
operating expenses. A higher margin percentage is a
favorable profit indicator.
 Operating profit margin (EBIT
Ratio)
Operating Profit Margin shows the profit that company earned after
deducting Its operating expenses. Here the profit is calculated prior to
the tax and interest expenses. After subtracting cost of goods sold
(COGS), and other direct operating expenses.

It is a preferred metric to make inter-company comparisons and

financial projections.
 Operating Ratio
This ratio indicates the portion of operating expenses or
operating costs compared to company sales. Operating
expenses include all expenses of the company except taxes
interest payments and non-operating expenses.
The lower operating ratio shows higher profitability and high
management efficiency.
 Pretax profit margin
The pretax profit margin measures the operating efficiency of a
company before reducing its tax burden.

The pretax profit margin is widely used to compare the profitability of

businesses within the same industry. Pretax profit can be calculate with
the following formula;
Pretax profit = taxes + profit after tax
Or
Pre-tax profit = Net Income / (1- effective tax rate)
 Net profit margin
Net profit presents the final income for the equity holders.
Additional Profitability Ratios - Effective tax
rate
It is the average tax rate at the company pay their taxes
compare to net income before the tax.

The formula to calculate effective tax rate is;

 Return on Assets
The Return on assets (ROA) ratio indicates how effectively
the organization uses its assets to generate profit. A higher
return implies more efficient asset management.
 Return on Equity
This ratio indicates the net assets generated for their average shareholder equity.

This shows the earning capability of shareholders for their investments in the
company.

The higher ratio presents efficient management to generate high return to

investors.
 Return on Capital Employed

ROCE gives a comprehensive understanding for their investors about the profit
generation compared to the company’s total capital.

Financial analysts consider that the ROCE is a more comprehensive profitability

indicator.
 Activity

Analyze the company’s profitability with

profitability ratios